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The Euro In Crisis Part 4: The Macedonian Captivity

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The Unfortunate General Trichet…

When Greece came to the European Central Bank requesting emergency bailout funds its then president, Jean-Claude Trichet, found himself and his bank in a precarious position.

On one hand, markets wanted a prompt response to the sudden onset of Greek insolvency, especially with the billions of Euros on the line if Greece were to default on its debts. Investors had watched the ECB sit idly by, watching the Celtic Tiger succumb to the perils of market speculation and wanted to see a European version of the “quantitative easing” magic performed by Ben Bernanke, chairman of the US Federal Reserve. However, even if Trichet had wanted to pursue such a course of action, it was unclear whether or not he had the legal authority to do something similar.

On the other hand, the accounting problems in Athens were steep and extensive, as the Greeks had been misrepresenting their debts since entering the Euro in 2000. Deals with Goldman Sachs and other American financial institutions were uncovered that had exposed billions of Euros worth of off the book liabilities and it wasn’t until November of 2009 that a reliable figure for Greece’s debt surfaced. At some €299.7 billion, it was clear that Greece would need far more than the €45 billion that it had initially requested, so an audit over three years of financial data was conducted.

Once the audit had finished in November, the real situation was revealed to be much worse than anticipated. Greece had a budget deficit that was 15.6 percent of GDP, a debt-to-GDP ratio of around 130 percent, and was paying higher interest rates to continue selling its bonds on the open market; all of which far exceeded the EU established ceilings. Trichet and the European Central Bank needed to act promptly to provide additional liquidity to Greece’s ailing financial sector in order to keep the nation from defaulting on its debts completely, an event that would have unimaginable consequences for the future of the Euro. 

The European Central Bank isn’t a “Federal Reserve of Europe,” in the sense that it cannot lend to any financial firm, at any price and at its discretion, like the US Federal Reserve System. If the ECB wants to lend, it has to verify that the borrowing bank has collateral adequate to justify the size of the loan. In theory, the EU’s internal controls on debt relative to GDP and government deficits should ensure that if one of the National Central Banks needs capital, its balance sheet will show collateral enough to justify the loan. Using an instrument called a repo contract, the ECB lends funds to the bank in need, expecting repayment at a given interest rate that it determines once the contract matures (normally a two to three week period).Trichet and the European Central Bank were faced with a difficult choice, knowing that Greece’s ailing financial sector couldn’t stand if the Bank of Greece contiued to issue bonds, but also knowing that Greece didn’t have the collateral to justify a multi-billion Euro loan to rescue its banks. Unfortunately for Greece Trichet made the legally proper, but unquestionably poor choice. The European Central Bank would not act, until Greece could lower its debt enough to satisfy concerns (largely from Germany and France) that it could repay the funds the ECB would loan it. 

The market reaction to this news was both swift and predictable. Greece’s credit rating was downgraded to junk status by S&P by April 2010, followed quickly by Moody’s and Fitch Ratings. The interest rates on its bonds rose to 15.3 percent that same month, and investors began retreating from any bank that was holding any amount of Greek debt-securities as fears of default permeated global markets. Without the ability to sell bonds on the open market, the Greeks went to the European Central Bank in April requesting €45 billion in new capital to bail out its heavily indebted financial sector. Pressured by Germany and France (who are the two largest contributors to its working capital), the ECB refused to intervene until Greece could lower its debt load to levels that were deemed acceptable. To achieve this, the Greek government implemented a series of spending reduction measures which included provisions that lowered the national minimum wage, enforced salary caps on public and private sector businesses, and dramatically increased VAT and income tax rates. The plan failed, largely due to poor tax reciepts and further news from the EU-IMF audits calling for more spending cuts and debt reductions. In May, Greece saw its credit rating reduced to CCC, the lowest rating in the world. 

But the shocks to the country weren’t just economic. A political crisis soon erupted, right after the birth of the financial one. The ECB’s decision to withhold bailout funds until more austerity was enforced was seen by Greeks as a Franco-German punishment that didn’t fit the crime. Certianly Greece hadn’t spent its money wisely, but the Italians, Spanish, and Portuguese had all proven to have had similar debt problems and accounting irregularities and weren’t faced with the same choices. The austerity measures were rapidly advancing unemployment, worsening living conditions and the citizens took to the streets in protest . The uprisings grew worse after the failure of the Greek parliament to pass the second round of austerity measures required to gain access to bailout funds, and Prime Minister Lucas Papademos called for a vote of confidence and a reshuffling of his cabinet. 

To add insult to injury, the ECB’s decision sparked a crisis in confidence not only in Greece, but also raising questions about the viability of the Eurosystem itself. Italy, Portugal, Cyprus, Spain, and eventually France, became subject to intense market speculation over their debt levels leading to credit downgrades and rising interest rates on their bonds. Trichet’s decision to keep the ECB out of the fray helped to accelerate the deterioration of financial conditions in the Eurozone as a whole; a costly lapse in judgement.

Where Does Greece Go From Here?

Overall, the economic situation in Greece is one of the worst in the Eurozone. It holds the lowest possible credit rating from Fitch, Moody’s and S&P so its central bank can’t sell its bonds to investors to generate new capital. Austerity measures have helped push its unemploment rate to 22.6 percent, the second highest in the Eurozone, behind Spain at 23.6 percent, and have largely stifled economic growth in the public and private sectors. Its debt-to-GDP ratio still hangs around 165.4 percent; and while the government has increased taxes, revenues continue to slide as economic conditions in Europe worsen. 

Above anything, what Greece needs is a way to generate economic growth by investing in projects to turn its unemployment rate around and make goods and services less expensive until it’s in a position to raise wages again. First, Greece should be allowed to reduce its VAT, or Value Added Tax, rate from 23 percent to 13 percent for all goods and services to which the current VAT rates apply. This reduction would cheapen the price of goods and services for consumers and businesses alike as consumers pay VAT to businesses when they purchase products and businesses pay VAT to each other for supplies used to manufacture what they sell. Lower costs make it easier for businesses to remain open or start anew, and help to buoy consumer spending despite lower incomes. 

Second, and most importantly, Greece must remain in the Eurozone. While its European partners have been slow to assist, Greece is much better off remaining in the Euro because without it, Greece could end up like Iceland did in 2008. The return of a Bank of Greece-backed drachma would not improve Greece’s overall financial health because there’s no reason why investors would feel more confident in a Bank of Greece that could raise its own inflation at will when it has already demonstrated management problems under tight internal controls and an expanded balance sheet. Also, Greece would need to increase the money supply to levels that could cause hyperinflation in order to satisfy its cash flow concerns, which would leave it financially worse than it is now with the Euro.

Lastly, the ECB needs to pursue policy that will allow Greece to invest its bailout funds into long-term growth projects while directly overseeing the process to ensure the funds are applied appropriately. Infrastructure and transportation are always good places to invest, as improvements in these sectors can create jobs year over year and improve the efficiency of commerce between regions. Spending reductions and tax hikes have done little more than ruin the Greek economy and choke opportunities for renewed growth. As its central bank and chief monetary policy authority, the ECB has an obligation to guide Greece back to solvency, which will only happen by generating growth, not killing it.

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About Alexander J Smith III